Aug. 5, 2016

A recent tax court case (Steinberger v. Commissioner, T.C. Memo 2016-104) involving a physician who asserted that the use of an airplane was to further his medical practice, and attempted to claim tax deductions, highlights a potential tax trap for the unwary.

The physician was one of several principals in a medical practice, as well as a pilot. He formed a disregarded entity LLC to own a Cirrus SR22. This LLC reported losses for a number of consecutive years, catching the attention of the IRS.

To apply IRS Section 183 (“hobby loss”) rules to an activity, the activity must first be ascertained. In this instance, the physician elected to combine the airplane LLC and the medical practice as one activity for some years, but not others. While grouping different activities to protect against the aircraft activity being viewed as a hobby loss is a common practice, in this case the court ruled that the grouping of aviation and medical activities was inappropriate ultimately disallowing the airplane LLC’s deductions by concluding there was no profit motive.

With the court’s description of the case, the disallowance of aircraft-related deductions as a hobby loss was not surprising, according to Sarah Caplan, with Business Tax Services at Deloitte Tax LLP.

In this case, Caplan finds the court’s emphasis on the importance of grouping statements attached to the physician’s return notable, since Treas. Reg. 1.183-1(d) does not provide detailed guidance on this process.

“The court appears to require a formal documentation of a taxpayer’s combination of activities for hobby loss purposes even though none is stated in the Treasury regulations.” said Caplan. “Documentation of groupings must be carefully considered, and this case provides insights into the tax court’s views.”

While the physician said the airplane was mostly used to expand the medical practice, the court didn’t fully agree, emphasizing the physician alone, and not the other six principals of the practice, was responsible for aircraft expenses. This allocation raised questions about the interrelatedness between the airplane LLC and medical practice.

According to the court, the LLC also had no basis to claim the flights saved any time (versus driving), nor did it further the profit motive of the medical practice, thus triggering the disallowance of deductions due to hobby loss rules and inappropriate grouping determination.

“The Treasury regulations appear to allow some flexibility in the ability to combine activities for hobby loss purposes, especially given that Treas. Reg. §1.183-1(d) states that “Generally the commissioner will accept the characterization by the taxpayer of several undertakings either as a single activity or as separate activities” said Caplan. “In light of this court case, aircraft owners and their advisers may want to look more carefully at how activities are combined.”

Caplan suggested reviewing certain factors for grouping elections, including, “How solid is the interrelationship between activities? Would your grouping factors likely hold up in court? And have you included an election to combine activities for hobby loss purposes with your tax return?”

These topics will also be covered at NBAA’s Tax, Regulatory and Risk Management Conference, Oct. 30 and 31 in Orlando, FL. Learn more about the conference.

Review the full court decision. (PDF)